Mighty Mo Is Back

As the bull market roared in the late 1990s, some of the top performers were momentum funds, including PBHG Growth and AIM Constellation. These focused on stocks with accelerating earnings or rising share prices. But when technology stocks began declining in the spring of 2000, the high-flying funds crashed, and momentum strategies fell out of favor. Many momentum funds changed their strategies or closed.

But not everyone has given up on momentum. In recent years, some momentum funds have delivered compelling returns. Strong performers include Monetta (MONTX) and American Century Heritage (ATHAX). AQR Capital Management, a big operator of hedge funds, has opened AQR Momentum (AMOMX), which has produced solid returns in its first year. “A momentum fund can help to diversify a portfolio that holds traditional growth and value funds,” says Ronen Israel, an AQR portfolio manager.

For two decades, investment researchers have provided support for momentum investing. According to the studies, stocks that outperformed for several months went on to excel for several more months on average. In a recent study, Ibbotson Associates looked at the performance of U.S. equity funds from 1995 through 2009. Portfolios that had performed best in the past six months were considered to have the greatest momentum. Funds with high momentum returned 10.8 percent annually, while portfolios with low momentum returned 3.9 percent.

Nothing Lasts Forever

While the academic evidence for momentum may be clear, applying the results has proved to be complicated. For starters, the persistence of results fades after a year or so. If you buy stocks with the best returns during the past five years, you will lag badly in the future, researchers found. The problem is that long-time winners become too expensive and slip back in the standings. In addition, momentum strategies tend to be volatile. During periods of consistent trends — such as roaring bull markets — momentum funds excel. But if the market shifts direction suddenly, momentum funds can sink like a stone. All too often investors have bought momentum funds when they were hot and sold at the first sign of trouble, a strategy that can result in terrible returns.

To get decent results, fund shareholders must be willing to stick with momentum strategies through downturns, says Daniel P. Weiner, CEO of Adviser Investment Management, an investment advisory firm in Newton, Mass. Weiner has long recommended putting some assets into a “hot hands” portfolio of Vanguard funds. For the portfolio, you select the diversified Vanguard portfolio that has performed the best in the past year. Then you hold the fund for one year. From 1981 through 2010, a model portfolio of hot Vanguard funds returned 16.4 percent annually, compared to 11 percent for Vanguard Total Stock Market Index (VTSMX). The hot fund for this year is Vanguard Small Cap Growth Index (VISGX), which returned 30.7 percent in 2010.

Weiner says that the approach has outperformed the benchmark in 20 of the last 29 years. Those who are inclined to try the strategy should be aware that the system has lagged badly in some years. In 2009, the hot hands fund — Vanguard Dividend Growth (VDIGX) — trailed the benchmark by 7 percentage points.

An innovative fund is AQR Momentum, which began operating in July 2009. During the past year, the fund returned 28.9 percent, outdoing 84 percent of large growth funds. To offer a pure dose of momentum stocks, the AQR portfolio managers screen the 1,000 largest U.S. stocks and buy the 300 names that have delivered the best performance in the past 12 months. The process is repeated every quarter.

While it holds many growth stocks, the AQR fund is different from traditional growth index funds. To design typical index funds, you divide the fund universe in half, with the most expensive names going into the growth category and the rest in value. But the AQR momentum fund takes any stocks that are rising. These include a mix of growth and value names. As a result, the AQR fund can help to diversify a portfolio because it does not precisely track growth. In addition, the momentum fund could outperform traditional growth benchmarks because value has often outdone growth over long periods. “Growth stocks can be overpriced,” says portfolio manager Israel. “A momentum fund can be a better version of growth.”

A strong-performing momentum fund is Monetta (MONTX), which has returned 4.8 percent annually during the past five years, outdoing 87 percent of large growth funds. Portfolio manager Robert Bacarella only buys stocks when all the indicators are strong. The stock price must be rising, and sales and earnings must also be growing. “If the fundamental performance is not solid, the share price will lose momentum,” he says.

To hold mid caps, consider American Century Heritage (TWHIX), which has returned 8.5 percent annually during the past five years, outdoing 98 percent of mid-cap growth funds. Portfolio manager David Hollond looks for companies with accelerating earnings. Not only should growth this year be faster than last year, but the trend must appear likely to continue for at least the next six months. While many holdings are long-term growers, Hollond will also take businesses that have been disappointing in the past and now are enjoying a sudden surge. “We like situations where there is a new product, and sales suddenly ramp up,” he says.

No matter how strong the earnings, Hollond will not buy unless the stock is also performing well. He looks for stocks that have been showing good relative strength for the past nine months. A favorite holding is AGCO (AGCO), a maker of farm equipment. Sales have been growing as farmers increase production in markets around the world.

For a small-cap choice that is different from traditional momentum funds, consider Turner Small Cap Growth (TSCEX), which has returned 4.2 percent annually during the past five years, outdoing 72 percent of peers. Portfolio manager Bill McVail likes growing companies in expanding industries. He favors strong businesses that are increasing margins or growing geographically. While he pays attention to movements of share prices, McVail does not let price momentum rule his decisions. If shares are rising on weak volume, he may look elsewhere.

While many growth funds focus on technology and consumer products, Turner stays broadly diversified with holdings in all sectors. The diversification helps to mute risk. A favorite holding is WESCO International, which distributes wiring and other electrical supplies used in construction. With commercial construction beginning to rebound, the company is reporting growing sales.